Macroeconomic Policy Objectives
Internal balance
• Full employment…maximum output
• Stable prices
– “Overemployment” rising prices
– Less-than-full-employment falling prices
– Volatile aggregate demand and output lead to volatile prices.
– Price level volatility  uncertainty inefficiency
External balance: Current account
– not so much in deficit to be unable to repay foreign debt
– not so much in surplus that foreigners can’t repay their debts
Achieving Internal and External Balance
Pegged rates
 Fiscal policy effective
 Exchange rate can be changed
– Devaluation/revaluation
 Tools:
• Expenditure changing: fiscal policy
• Expenditure switching: exchange rate setting
– Need as many tools as you have objectives
 For external balance, XX
– G up  Y up  CA down … unless E up (devaluation)
 For internal balance, II
– E down (revaluation)  CA down  Y down … unless G up
Internal Balance (II), External Balance (XX) “Four Zones
of Economic Discomfort”
The Open-Economy Trilemma
The Impossible Trilogy

Impossible for a country to achieve more than two items from the
following list:
1. Exchange rate stability…fixed (or managed) rates
2. Monetary policy for internal balance.
3. Freedom of international capital movements.
The Policy Trilemma for Open Economies
Macroeconomic Policy Under the Classical Gold Standard:
1870–1914

Mechanisms keeping official gold flows (the balance of payments)
from becoming too positive or too negative.
Gold stock  Money supply  Price level  Current account
Hume’s Specie Flow Mechanism
Gold stock  Money supply  Output&income  Current account
Gold stock  Money supply  Interest rate  Capital flows
Central banks management of bank rate
– Keep private capital flows ≈ Current account
“Rules of the game” not followed
Gold stock  Financial influence  Sterilize gold inflows
Central bank cooperation
– Lending to keep gold stocks stable
The Gold Standard and Internal Balance
• The US economy, 1873 – 1913
– Deflation
– Frequent financial crises
– Frequent recessions
– 1890 – 1913 unemployment: 6.8% on average
– 1946 – 1992 unemployment: 5.7% on average
WW I: Capital flight  breakdown of gold standard
 Interwar turbulence
– Legacies of WW I
– Redrawn borders  disrupted trade patterns
– Overhang of “Old Debts”:
» reparations/inter-allied loans
– Labor empowered: The eight hour day
Excessive claims  hyperinflation

Gold Standard Nostalgia
• Restore London dominance
$ Dominance/New York Dominance
 Classical gold standard, 1870 – 1914
• £ dominant despite US economic prowess
– US banks couldn’t branch overseas
– Bimetalism and its legacy  $ looked risky
 WW I  £ instability
$ denominated transactions w/Latin America, Asia
– Federal Reserve fostered market in int’l acceptances
– Benjamin Strong and his legacy
– Post-war credit in $s
– European government bonds denominated in $s
– National City Bank/Others/Branching Abroad
 US financial dominance: from mid-1920s
• International economy disrupted in depression, WWII
‘20s Halting return to gold  Prelude to depression
– The Economic Consequences of Mr. Churchill
 General Strike
– US monetary expansion – help to Britain  Roaring ’20s
– Capital flow reversal  European downturn
le and collapse
– Bu b b
‘30s World in Depression: Who Leads?
UK couldn’t …US wouldn’t  Protection … beggar thy neighbor
1931 European banking crises and contagion
– Creditanstalt  German banks  British investment banks
 Flight from the £
September 1931: Britain leaves gold – US defends gold standard
 Crisis and the Great Depression
Golden fetters
– Halting recovery: monetary expansion/fiscal measures/rearmament



Postwar: Restore Stability  Bretton Woods System
IMF a bank/World Bank a fund
$ pegged to gold … N – 1 currencies pegged to an elastic $
IMF: International lender of last resort

Capital controls on international financial transactions
• support pegs
• allow devaluation when fundamental disequilibrium
• Protect financial account/Prevent balance of payments crisis



Currencies were convertible to encourage trade in goods and services
Fiscal policy the principal tool for internal balance
Principal tools for external balance
• borrowing from the IMF
• restrictions on financial asset flows
• infrequent changes in exchange rates.
Policy Mix for Internal and External Balance:
2 Goals – 2 Tools
Starting with CA Deficit and Underemployment
 Fiscal stimulus + Devaluation
•
Under the fixed exchange rates of the Bretton Woods system,
devaluations were supposed to be infrequent
–
•
•
•
fiscal policy was supposed to be the main policy tool to
achieve both internal and external balance.
In general, fiscal policy cannot attain both internal balance and
external balance at the same time.
A devaluation, however, can move toward both internal balance and
external balance at the same time.
Speculator anticipation of devaluation  greater internal or external
imbalances.
Reserve Currencies in Int’l Monetary System
Bretton Woods: $ Standard…more flexible than gold


Each central bank fixed the dollar exchange rate of its currency through
foreign exchange market trades for $s
• Exchange rates between any two currencies fixed by arbitrage.
The US could use M-policy for macroeconomic stabilization despite fixed
rates.
Purchase of domestic assets by the Federal Reserve leads to
– Excess US demand for foreign currencies in the foreign
exchange market
– Purchases of $s by foreign central banks to keep $ from
depreciating
Expansionary monetary policies by all other central banks
– Higher world output … and/or INFLATION
Bretton Woods System
Problems/breakdown:
– Speculative attacks against weak currencies
– Gold & $ Shortage
Buildup of $ reserves > US gold stock
– $ Glut
Vietnam era expansion  Pus up  overvalued $
 Rush out of $s…try to redeem gold the US doesn’t have
– Nixon Economic Program, August 15, 1971
– Close gold window…8% devaluation against gold in 12/71
– Import surcharge
– Wage/price controls
– 1973 Collapse of Bretton Woods system
– Foreign central banks refused to buy overvalued $ assets
Exporting US Inflation:
1966–1972
Effect on Internal and External Balance of a Rise in the Foreign (US)
Price Level, P*
The “simple” solution for the £, DM,
¥, FF, …
• Revalue against the $
The Case for Floating Exchange Rates
• Monetary policy autonomy…w/o capital controls
– Each country can choose “appropriate” long-run inflation rate
• Symmetry
– $ can “devalue” as necessary…not constrained as leader
– Other countries can use monetary tool
• Exchange rates as automatic stabilizers
– Floating cushions output against real shocks
– Something’s gotta adjust…if not E, then Y
– Depreciation in the face of reduced demand for a nation’s
exports restores equilibrium automatically
– Unlike Bretton Woods
» there would be a “fundamental disequilibrium”
» and ongoing CA deficit and loss of reserves
» until price level fell or currency devalued
The Case for
Floating Exchange Rates
Effects of a Temporary Fall in Export Demand
Exchange rate, E
DD2
DD1
2
E2
(a) Floating
exchange rate
1
E1
Depreciation
leads to higher
demand for and
output of
domestic products
AA1
Y2 Y1
Exchange rate, E
Output, Y
DD2
DD1
(b) Fixed
1
exchange rate E
3
1
AA2
Y3 Y2 Y1
Fixed exchange
rates mean output
falls as much as
the initial fall in
aggregate demand
AA1
Output, Y
The Case Against Floating Exchange Rates
 Lack of discipline
… but a floating exchange rate bottles up inflation in a country
whose government is “misbehaving”.
 Destabilizing speculation
• Hot money
…but “fundamental disequilibrium”  one-way bet under fixed rates
• Countries can be caught in a “vicious circle” of depreciation and
inflation. E deprec Pim up CoL up W up P up
 E deprec
• Floating exchange rates make a country more vulnerable to money
market disturbances: L up  R up  E-apprec.  CA & Y down
– Fixed rates cushion output against monetary shocks
L up  M up  nothing shifts under fixed rates
The Case Against Floating Exchange Rates
A Rise in Money Demand Under a Floating Exchange Rate
Exchange
rate, E
DD
1
E1
2
E2
AA1
AA2
Y2
Y1
Output, Y
What really matters?
 Recall:
• With fixed rate, monetary policy is ineffective (given free
•
capital flows)
– Similarly, monetary shocks have no real effect
With floating rates, fiscal policy is ineffective
– Similarly, temporary real shocks [like drop in demand
for exports] have little real effect
– Permanent real shocks have “no” real effects
The Case Against Floating Exchange Rates
 Injury to International Trade and Investment
• Exporters and importers face greater exchange risk.
– But forward markets can protect traders against foreign exchange risk.
• International investments face greater uncertainty about payoffs
denominated in home country currency.
 Uncoordinated Economic Policies
• Countries can engage in competitive currency depreciations.
…under Bretton Woods, policies “coordinated” via US privilege
• A large country’s fiscal and monetary policies affect other
economies
…aggregate demand, output, and prices become more volatile
across countries if policies diverge.
 Free Float Really Managed Float
• Fear of depreciation – inflation spiral  intervention
The Case Against Floating Exchange Rates
•
Speculation and volatility in the foreign exchange market
• If traders expect a currency to depreciate in the short run, they
may quickly sell the currency to make a profit, even if it is not
expected to depreciate in the long run.
• Expectations of depreciation lead to actual depreciation in the
short run.
• The assumption we’ve been using that expectations do not
change when temporary economic changes occur is not valid
if expectations change quickly in anticipation of even
temporary economic changes.
• In fact, exchange rate volatility has increased since 1973
Macroeconomic Data for Key Industrial Regions,
1963–2009
The Case Against Floating Exchange Rates
Floating and Discipline:
Inflation Rates in Major Industrialized Countries, 1973-1980
(percent per year)
Nominal and Real Effective Dollar Exchange Rate Indexes,
1975–2006
Purchasing Power Parity???
Source: International Monetary Fund, International Financial Studies.


Due to contractionary monetary policy (Volcker disinflation) and
expansive fiscal policy (Reagan tax cut and military buildup, the $
appreciated by about 50% relative to 15 currencies from 1980–1985.
 growing US CA deficit & rest-of-world capital shortage
Major efforts to influence exchange rates:
• The 1985 Plaza Accord reduced the value of the dollar relative to
other major currencies… “bringing down dollar”
• The 1987 Louvre Accord: intended to stabilize exchange rates
– Specified zones of +/- 5% around which current exchange
rates were allowed to fluctuate.
–
Quickly abandoned
– The October 1987 stock market crash made production, employment
and price stability the primary goals for the U.S.
» Did tightening to support $ trigger “Black Monday”?
» After Black Monday, exchange rate stability became less important.
– New targets were (secretly) made after October 1987, but central banks
had abandoned these targets by the early 1990s.
Macroeconomic Interdependence Under Floating Rate
The Large Country Case
• Effect of a permanent monetary expansion by US
– $ depreciates, US output rises
– Foreign output may rise or fall.
– Foreign’s currency appreciates  Foreign’s output falls
– US economy expands Foreign sells more to US
• Effect of a permanent fiscal expansion by US
– US output rises, US currency appreciates
– Foreign output rises
– Foreign’s currency depreciates  Foreign’s output rises
– US economy expands  Foreign sells more to US
Large Country => Locomotive
Exchange Rate Trends and
Inflation Differentials, 1973–2009
High-inflation
countries have tended
to have weaker
currencies than their
low-inflation
neighbors.
Source: International Monetary Fund and Global Financial Data.
Global External Imbalances, 1999–2009
Source: International Monetary Fund, World Economic Outlook database.
•
The U.S. has run a current account deficit for many years due to its low saving and
high investment expenditure.
Rebalancing: As foreign countries spend more and lend less to the U.S.,
interest rates may rise
the U.S. dollar will depreciating
the U.S. current account will improve (becoming less negative).
•
•
•
Long-Term Real Interest Rates for the United States,
Canada, and Sweden, 1999–2010
Source: Global Financial Data and Datastream. Real interest rates are six-month moving averages of monthly
interest rate observations on ten-year inflation-indexed government bonds.
Macroeconomic Interdependence Under Floating Rate
Unemployment Rates in Major Industrialized Countries,
1978-2000 (percent of civilian labor force)
What Has Been Learned Since 1973?
• After 1973 central banks intervened repeatedly in the foreign
exchange market to alter currency values.
– To stabilize output and the price level when certain
disturbances occur
– To prevent sharp changes in the international competitiveness
of tradable goods sectors
• Monetary changes had a much greater short-run effect on the
real exchange rate under a floating nominal exchange rate
than under a fixed one.
• The international monetary system did not become symmetric
until after 1973.
– Central banks continued to hold dollar reserves and intervene.
• The current floating-rate system is similar in some ways to
the asymmetric reserve currency system underlying the
Bretton Woods arrangements … exorbitant privilege
What Has Been Learned Since 1973?
 The Exchange Rate as an Automatic Stabilizer
• Experience with the oil shocks of 1973 and 1979 favors
floating exchange rates.
• The effects of the U.S. fiscal expansion after 1981 provide
mixed evidence on the success of floating exchange rates.
 Discipline
• Inflation rates accelerated after 1973 and remained high
through the second oil shock.
• The system placed fewer obvious restraints on unbalanced
fiscal policies.
– Example: The high U.S. government budget deficits of the
1980s.
What Has Been Learned Since 1973?
 Destabilizing Speculation
• Floating exchange rates have exhibited much more day-today volatility.
– The question of whether exchange rate volatility has been
excessive is controversial.
• In the longer term, exchange rates have roughly reflected
fundamental changes in monetary and fiscal policies and not
destabilizing speculation.
• Experience with floating exchange rates contradicts the idea
that arbitrary exchange rate movements can lead to “vicious
circles” of inflation and depreciation.
 International Trade and Investment
• For most countries, the extent of their international trade
shows a rising trend after the move to floating.
 Many fixed exchange rate systems have developed since
1973.
• European monetary system and euro zone
• The Chinese central bank currently fixes the value of its currency.
• ASEAN countries have considered a fixed exchange rates and
policy coordination.